1. Tax Base Volatility (Update) Thomas Stinson Matthew Schoeppner July 22, 2008

2. Summary Minnesota’s tax base has grown more volatile The volatility of MN’s current tax base appears to increase during recessions The volatility of the tax system can be reduced by relying more on less volatile revenue sources or by changing the volatility of existing revenue sources At current levels of volatility MN’s biennial budget reserve should equal approximately 4.1% (or $1.4B in FY06-07) of biennial revenues

3. Measuring a Growth & Volatility Example: Wages and Salaries Trend Growth Rate (Hodrick Prescott Filter)

4. Measuring a Trend Growth Rate Example: Wages and Salaries Trend Growth Rate (Hodrick Prescott Filter) Hodrick Prescott Filter uses a trend component and a cyclical component to obtain a smoothed non-linear representation of the long term trend growth rate of a data-series.

5. Measuring Volatility Example: Wages and Salaries Trend Growth Rate (Hodrick Prescott Filter) GARCH Model is a time variant measure of statistical dispersion (σ) based on the assumption that volatility changes over time. The model captures both short-term high-frequency volatility as well as long-term influences. 0.9% 2.3% Volatility Measure (GARCH σ )

6. Volatility Calculation Summary Method – Hodrick-Prescott filter estimates a trend growth rate – GARCH model estimates volatility (σ) from trend growth rate over time – Markowitz’s modern portfolio theory (MPT) is used to estimate the volatility of 4 major revenue sources of MN’s tax system: Portfolio trend growth rate: weighted sum of the individual component’s growth rates Portfolio volatility: weighted sum of the variances and covariances of the individual components – Volatility of MN’s total tax system estimated using MPT model and volatilities of 4 major revenues

7. Data Summary MN Tax Portfolio: 4 Major Revenue Types – Individual Income Tax: 7 income types (Source: IRS SOI) – General Sales Tax: 19 purchase categories (Source: BEA NIPA tables) – Corporate Franchise Tax: domestic profits (Source: BEA NIPA tables) – Other Taxes and Non-Tax Revenue (Source: U.S. Census)

8. 2.3% 3.3% 6.0% 12.3% 15.2% 27.3% Salaries & Wages Taxable Interest

9. 2.3% 3.3% 6.0% 12.3% 15.2% 27.3% Salaries & Wages Taxable Interest 3.1%

10. 2.6% 2.1% 10.9% 12.1% 3.1% 2.0% 2005-2007 Trend Growth Rate of General Fund Tax Base Corporate Income Tax Base 14.9% Individual Income Tax Base 5.4% MN Sales Tax Base 5.2% Other Revenue Tax Base 11.0% Total Portfolio 6.5% Inflation 2.6% 3.8% 10.3% 2.1% 2.4%

11. 2.6% 2.0% 2.2% in 1987 2.1% in 1996 2.8% in 2002 2.5% in 1991 2.5% in 1983

12. 2.6% in ‘87 3.0%-3.1% in ‘99, ‘01 & ‘02 2.6% in ‘91 3.0% in '83 2.7% in ‘97

13. Summary Minnesota’s tax base has grown more volatile The volatility of MN’s current tax base appears to increase during recessions The volatility of the tax system can be reduced by relying more on less volatile revenue sources or by changing the volatility of existing revenue sources At current levels of volatility MN’s biennial budget reserve should equal approximately 4.1% (or $1.4B in FY06-07) of biennial revenues

14. 2.4% 2.6% 1.5% 1.9% 12.1% 27.3%

15. 2.4% 1.5% 1.9% 2005-2007 Annual Trend Growth Rate of Other Non-Taxed Consumption Food (excl. Candy and Soft Drinks) 5.8% Clothing and Shoes 4.0% Prescription and Nonprescription drugs 5.9% Total MN GF Tax Base (post MVST) Portfolio 6.5% Inflation 2.6%

16. Summary Minnesota’s tax base has grown more volatile The volatility of MN’s current tax base appears to increase during recessions The volatility of the tax system can be reduced by relying more on less volatile revenue sources or by changing the volatility of existing revenue sources At current levels of volatility MN’s biennial budget reserve should equal approximately 4.1% (or $1.4B in FY06-07) of biennial revenues

17. Calculating the Appropriate Size for Minnesota’s Budget Reserve Convert annual estimated tax base volatility to GF revenue volatility (3.03% post MVST) Choose how often it is acceptable for the budget shortfall to exceed the budget reserve (1 in 20, 5%) Multiply annual revenue volatility estimate by the critical failure rate value to obtain the % shortfall exceeded 1 in every 20 times (3.03*1.645 = 4.98%) (critical value for a 5% one tail z test = 1.645) MN budgets on a 2 year basis. Biennial reserve found using the same procedure but for two years.

18. Tax Source FY 2005-2007 Share of GF Total Revenue 2Yr Trend Growth Rate 2Yr Volatility (σ) General Sales 28.64%10.92%3.51% Corporate Income 6.83%36.05%16.91% Individual Income 44.25%10.94%5.74% Other Revenues 20.29%14.38%6.42% Total GF Portfolio100.00% 13.35%4.57% Final Results : With 95% Confidence (one tail or z = 1.645) an appropriate... Biennium Budget Reserve: 4.1% (of Biennial Current Resources) For Example, in FY06-07 (Thousands $) FY06 Resources FY07 Resources FY06-07 Resources $17,355,445$18,192,177$33,734,477 With 95% Confidence an appropriate FY06-07... Biennium Budget Reserve:$1,368,000 Actual FY06-07 Budget Reserve:$653,000 Cash Flow Account:$350,000 Appropriate Budget Reserve for Post-MVST General Fund 2-Year Portfolio Method

20. Appropriate 2 nd Year Budget Reserve for Post-MVST General Fund 1-Year Portfolio Method Tax Source FY 2005-2007 Share of GF Total Revenue 1Yr Trend Growth Rate 1Yr Volatility (σ) General Sales 28.64%5.23%2.06% Corporate Income 6.83%14.94%12.03% Individual Income 44.25%7.25%3.88% Other Revenues 20.29%8.55%5.24% Total GF Portfolio100.00% 7.46%3.03% Final Results : With 95% Confidence (one tail or z = 1.645) an appropriate... 2 nd Year Budget Reserve: 5.0% (of Year 2 Current Resources) For Example, in FY06-07 (Thousands $) FY06 Resources FY07 Resources FY06-07 Resources $17,355,445$18,192,177$33,734,477 With 95% Confidence an appropriate FY06-07... 2 nd Year Budget Reserve:$910,000

22. Thank You